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Wednesday, September 22, 2010

Bearing Limit and Financial Regulation

An excellent keynote address by Avinash Persaud at the Long Finance conference yesterday, in which he deployed a few apparently simple ideas about risk management to mount an eloquent and powerful critique of the Basel 3 regulatory regime.

Here is a crude summary of some of the key points of Persaud's argument

1. Regulation should be counter-cyclical. Credit mistakes are made during the boom and exposed during the downturn. Regulation therefore needs to be stricter during the boom and relaxed during the downturn.

2. Basel 3 attempts to regulate risk in terms of risk sensitivity. This concept has several flaws.

It focuses on the private risks to banks and their shareholders, rather than the public risks to system and society.

It is based on the market price of risk, which is cyclical and therefore cannot support counter-cyclical regulation.

It assumes that all risk is homogeneous.

3. Financial risk is not homogeneous. There are different types of risk, which call for different kinds of hedging over different timescales. Persaud identified three types.

Credit risk denotes the risk that a given creditor will be unable to pay. This risk is mitigated by having a portfolio of uncorrelated creditors, and assuming that the failure of each creditor is a statistically independent event.

Liquidity risk denotes the risk that a given asset cannot be sold at short notice for the desired amount. This risk is mitigated by a preparedness to hold assets for long periods.

Market risk is a combination of credit risk and liquidity risk.

3. Banks are good at dealing with credit risk and bad at dealing with liquidity risk. Insurance companies and pension funds should be good at dealing with liquidity risk, provided they are not forced into inappropriate measures by stupid regulation.

4. Sustainable long-term investment entails liquidity risk. A regulatory regime that supports credit risk and fails to support liquidity risk tends to militate against sustainable long-term investment. But this is exactly the outcome of the Basel 3 regulations, according to Persaud. Instead, he argues, we need a regulatory regime that encourages firms to take appropriate long-term risk, according to their risk absorptive capacity.

5. The Basel 3 regulations force risk to be misallocated, because of a failure to appreciate time and its effect on risk. The goal of regulation should not be on reducing risk sensitivity but on increasing risk absorptive capacity.